Don’t Fear the Bubble

When asked if he thought we were seeing a tech bubble, Warren Buffett emphatically said, “I don’t see it. I would see it if it was a really big bubble,” he said. “I certainly saw it in the late 1990s. We don’t have that situation now. We do not have a big bubble market now.’

In contrast, hedge-fund manager David Einhorn recently said, “Now there is a clear consensus that we are witnessing our second tech bubble in 15 years. What is uncertain is how much further the bubble can expand, and what might pop it."

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Having officially called the tech bubble myself, I’m clearly in the Einhorn camp on this one. And while it’s tempting to infer that the Oracle of Omaha doesn’t know squat about Silicon Valley, it’s entirely possible that Buffett is not as out of touch as he appears to be.

The thing is, this bubble is very different from its dot-com predecessor. In this case, the devil is very much in the details.

While Einhorn and I agree that traditional valuation methods have gone right out the window for certain momentum plays like Internet, cloud computing, and social media stocks, that’s not necessarily the case for the broad tech sector, let alone the entire market.

Of about 50 public tech companies I follow on a daily basis, half are losing money and, of those that are profitable, about a third have stratospheric valuations.

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Despite trading at a 52-week low – having lost 40% of its value over the past six months – LinkedIn (NYSE:LNKD)is still trading at a whopping price-to-earnings multiple of 663. Likewise, Amazon has a P/E of 462, even though the e-commerce giant has shed 25% of its share price since January.

Facebook’s P/E is a tame 72 by comparison, but its price-to-sales ratio is 16. I’d call that off-the-charts … if Twitter’s (NYSE:TWTR) wasn’t more than twice that at 35. And enterprise cloud company Workday (NYSE:WDAY), which lost nearly half its value in just two months, is still somehow trading at a price-to-sales multiple of 25.

While the Nasdaq has reacted to fears that stocks are overpriced – dropping 6.5% since its 2014 peak of 4357 – the tech-heavy exchange had several even larger pullbacks on its way up to its all-time-high of 5132 in early 2000. And we all know what happened after that.

Private company valuations are even more unreasonable. About 50 venture-backed startups are currently valued at over a billion dollars. That should come as no surprise, since public companies like Facebook are using funny money from their own IPOs to buy tiny startups like WhatsApp for $19 billion.

While that would all seem to add up to a mountain of evidence that we are indeed in bubble territory – as I believe we are – there’s still one very important question we need to ask ourselves, and that’s how much further do we have to go before it bursts?

As Benchmark Capital’s Bill Gurley explained back in January, investors who pull out too soon can lose out on enormous returns. While Gurley was speaking of his business, venture capital, that logic holds true for public markets, as well. The Nasdaq actually doubled during the six months leading up to its peak in 2000.

All things considered, Buffett may have a point. Even if we are in a bubble, it certainly appears to be limited to a segment of the market. While that’s a relatively broad segment, it could be a big mistake to throw the baby out with the proverbial bath water – strange as that particular metaphor may be.

Which is why Einhorn’s strategy is to short a group of what he believes are overpriced momentum stocks. Risky as that approach may be for the average investor, it’s certainly a reasonable play for a hedge-fund manager looking to, well, to hedge against a bubble that will almost certainly burst.

Even Buffett acknowledged that’s bound to happen … some day. In the meantime, the guy’s got $100 billion in the market via Berkshire Hathaway. That, my friends, is a lot of air cover. Even though we’re seeing a tech bubble, that doesn’t mean you should run and hide.